The old adage, sell in May and go away, took on a new meaning with all equity markets and sectors having a negative return, with only nominal government bonds posting gains in May.
Was this a correction or does it signify a return to bear markets? The current bout of risk aversion has several negative strands. First, there is the financial stress due to the link between sovereign risk and the banking system. Second, some positions, particularly in commodity currencies, were possibly a little too overvalued so markets broke important technical support levels. Third, there was the fear of a significant economic downturn together with tighter monetary policy in China and the smaller developed countries. Fourth, this was all topped off by regulatory and fiscal uncertainties with Basel III, the short-selling ban and an Australian special tax on mining companies.
However, on balance, the financial stress faced by governments and commercial banks is less likely to spill over to the economy. Also, fundamentally restrictive fiscal policies in G4 over the next few years should be offset by low inflation and interest rates being lower for longer and weaker currencies supporting exports towards emerging markets. Corporate balance sheets and profits are in reasonable shape, although the spectre of higher corporate taxes could undermine this in the short term. On a historic basis, valuations are attractive but continued regulatory and fiscal uncertainties will probably add to the level of volatility.
Given this backdrop, what areas would be favour? Technical analysis will inform you the correction has seen the one-year-old uptrend being broken in the main markets. On the other hand, based on fundamentals and valuation, equities are still in relatively cheap territory.
In bond markets, it is easier to make the case for favouring corporate and emerging market bonds over government bonds as credit has widened on the back of higher risk aversion and corporate and emerging market bonds are not seen as being at the heart of the problem. Conversely, despite very attractive valuation levels, European banks suffer from eurozone sovereign bonds uncertainties and this is likely to continue as the Greek tragedy plays out. In respect of fundamentals, corporate and emerging markets remain strong with typically high cash balances and low gearing with emerging market countries very much less indebted than G4.
Paul Kim is director at FundQuest